"As to Bonaparte, he was well assured that nothing remained for him but to choose between that hazardous enterprise and his certain ruin."
-Memoirs of Napoleon Bonaparte, by Bourrienne

Thursday, April 9, 2009

Corporate Earnings plunging

Here are the total quarterly operating earnings for the S&P 500 companies (annualized). This excludes non-operating write-downs. Actual "as-reported" GAAP earnings are worse. Quite a plunge! S&P estimates that earnings will rebound some in 2009. I have my doubts. The S&P 500 is currently (Feb 10, 2009) at 834. So if 2009 earnings come in around 55, and the S&P trades at 15 times that, we come up with 825 which is about the current price. If it comes in at 30 (basically where it is in Q4 2008), the S&P may drop to 450 using 15X earnings.

The S&P earnings for 2008 were $27.7 using the Q4 estimates with 85% of companies having reported. The S&P 500 is trading at 827 which puts the P/E ratio at 29.86 which is one of the highest ever. According to the trailing PE, stocks are not cheap. In fact, they are amazingly expensive. However, there is something wrong with that argument. It has to do with the way things are averaged. For example, if the average PE is 29, one might think that there must be roughly half of companies trading at more than 29 times trailing earnings. Well, lets look and see. In the Dow 30, there are three companies with negative earnings in 2008 (C, GM and AA). Ignoring these three, here are the five with the highest trailing PE ratio: JPM (18.1), KO (17.0), MCD (15.1), INTC (15.0), WMT (13.5). Hmm, this is a funny kind of average when the top 5 have a lower than average PE. What is going on?

Well, S&P calculates the total earnings of the 500 companies making up the average. Then it is calculates the total market value. The it divides both by the same number (about 8700, called the divisor, it doesn't matter really) to report the S&P stock market index value and also the "earnings". The idea is that people then know about what the average PE is. However, this is not the same as < P/E >. Rather it is more like < P > / < E>. The two are not equal. For example, lets suppose that one company (lets call it Citigroup) loses $1 Trillion next year and goes bankrupt but the other 499 companies make $1.2 Trillion. Together then have made a net $0.2 Trillion. Lets say the total market cap of the 500 companies is $10 trillion. That looks like a PE of 50. Wow, pretty expensive right? Well, not really. Citigroup's weighting for the S&P is currently 0.27%. So if C goes to zero it reduces the index by a 0.27%. But then it gets replaced in the index by some other company that is unlikely to lose $1 Trillion the following year. People owning the index say good riddance to Citigroup and move on. In reality, they own an index at 8.3 times earnings not 50. Stock holders have limited liability. If C goes to zero, it doesn't matter how many gazillions of dollars they lose. The stock holders are not on the hook for it. Stock's can't have negative value.

It is important to consider the earnings weighted by the same weighting used in the S&P index which is by market cap. These can be found here .The top 45% of the index includes only two banks, JPM and WFC. If you wipe out the shareholders of JPM, C, BAC, GS and MS you have wiped out only 4.02% of the total index. That is just a bad day in the stock market these days. The S&P 500 companies have annual operating earnings of roughly $500B. These five banks could easily lose that much money in 2009 if they properly market down assets to market value.

So lets go back to the current situation and look at some numbers gathered from my Morningstar account. I screened for the largest 500 companies by market cap and trading on either the NYSE or NASDAQ which is a decent proxy for the S&P 500 companies. Then I can rank them by various quantities to get some statistics. Here are some results.

First the trailing 12 month PE ratios. The median is 10.0. The quartiles (25 and 75 percentiles) are 7.0 and 15.7. The median price-to-cash-flow is 7.3. The median forward PE is 10.3. So according to this, stocks are not particularly expensive. In fact those are below average valuations.

Of course, stocks could be expensive if earnings drop a lot and if analysts are wrong about next years earnings (almost certainly the case). For example the median price-to-book-value (P/B) is 1.9. The median return-on-equity is 18.7%. Both are pretty high still. For the major bear market bottoms of the 20th century (1920, 1932, 1949, 1974, 1982) the average P/B came down to roughly 0.5 almost four times lower than now. Profitability is still quite high. That is likely to change.

To see this, consider the ratio of corporate earnings to GDP. See chart here . This ratio should be mean reverting if capitalism is functioning properly. Excess profits should attract capital investment until the excess profits go away. This chart shows that the ratio peaked at 10% in 2007. The average value is about 6% with a low around 3%. It is probably best to assume that this ratio will drop to 3% before rebounding back to the mean of 6%. Looking at our chart above, we see that S&P 500 operating earnings peaked at about 90. So assuming constant GDP (a decent approximation), that means if the corporate earnings to GDP ratio goes to 3% before rebounding to 6%, the S&P 500 earnings will drop to 27 before rebounding to 54. The normalized earnings is probably close to this number, 54. The value of the S&P 500 is probably about 15 times this or 810 which is not far below today price of 827.

So stock are probably fairly valued. However it is still likely I think that they go lower. Usually after a period of over-valuation, there is a period of undervaluation. If earnings really hit 27 and the economy is really, really bad with unemployment over 10%, I would not be surprised for stocks to trade at 10 times normalized earnings or 540. If earnings drop to 27, that would be 20 times trailing earnings which might not appear cheap to people expecting the current conditions to continue indefinitely (which is human nature). That would still likely leave the average P/B above 1 which would well above previous bear market bottoms. Given the different nature of today's non-capital intensive, service oriented companies, that might make sense. If we have a depression, earnings could go lower still. Earnings were negative during the Great Depression. If we have something similar and earnings go negative, stocks will trade based on book value and if they fall to 0.5 book, that mean the S&P near 220. I don't see that happening but it is not outside of the realm of what has happened in the past.

####### Update ########AIG is going to post a $60B loss for Q4 which is much worse than the $12B loss that analysts expected. This will bring done the Q4 number for the S&P by about $5.50. The trailing PE for the S&P is now about 36 which is the second highest ever. The only year that ended with a trailing PE this high was 2001 when it was 46.

######## Another update ###########The Q4 is now done. I was right about AIG but underestimated other losses. The final tally for Q4 was -$23.25. Wow! S&P now estimates "as reported" earnings for the next three quarters. $7.32, $6.64, $7.46. Note that those three add up to only $21.42 so if they are right about these, the trailing 12-month earnings will be negative in Q3 2009.

Yes, I know, you can't make a sensible PE based on a negative number for earnings. For example the PE is predicted to be 1875 in Q2 and -450 in Q3. Ok, ok, lets look past "as reported" earnings and look at operating earnings which ignore one time losses and non-cash write-downs. We will make pretend that those things don't matter. S&P makes operating earnings predictions in two different ways: top-down estimates, looking at the macro picture and predicting total earnings and also a bottom-up picture, adding up the total earnings predicted by analysts of each company.

Using the top-down estimates, the forward operating earnings PE is 25 in Q3 and 18 thereafter. Using bottom-up estimates it is 18 in Q3 and about 12 thereafter. So there is a huge difference. I am more inclined to believe the top-down estimates especially if we are going to agree to ignore the "one-time" losses which have a habit of repeating themselves. I think analysts are making the incorrect assumption that companies can cost-cut their way back to profitability. I don't think this will work when everyone is doing the same thing. It just results in higher unemployment and less demand.